PARETO IMPROVEMENT: Based on the Pareto efficiency criterion, the notion that an action improves efficiency if it is possible for one person to benefit without anyone else being harmed. A Pareto improvement is possible if the economy has idle resources or market failures. With idle resources, more production is possible to help some without hurting others. With market failures, corrective actions can eliminate deadweight loss that can then be use for benefits economy-wide. A contrasting condition for attaining efficiency is the Kaldor-Hicks improvement.

The price elasticity of the demand curve facing a monopoly firm determines if the marginal revenue received by the monopoly is positive (elastic demand) or negative (inelastic demand). This relationship is important for the profit-maximizing production decision that involves equality between marginal revenue and marginal cost. It implies that a monopoly can only maximize profit in the elastic range of the demand curve.

The relation between the price elasticity of demand and the marginal revenue curve indicates that a monopoly is only able to maximize profit by producing a quantity of output that falls in the elastic range of the demand curve. A monopoly cannot maximize profit in the inelastic range of demand because this involves negative marginal revenue, and by virtue of the profit-maximizing equality between marginal revenue and marginal cost, it requires negative marginal cost, which is just not a realistic possibility.

The connection between marginal revenue and elasticity works like this:

A Look at the Curves

Revenue and Elasticity

To see how this looks, consider the exhibit to the right, which depicts the revenue (total, average, and marginal) received by a well-known monopoly, Feet-First Pharmaceutical. Feet-First Pharmaceutical is the exclusive supplier of the hypothetical drug Amblathan-Plus, the only known treatment for the hypothetical foot ailment, amblathanitis.

The top panel in the exhibit presents a hump-shaped total revenue curve (TR). It is hump-shaped because Feet-First Pharmaceutical does not charge the same price for each quantity sold. As a monopoly, it must lower the price to sell more output.

The bottom panel then presents the average revenue curve (AR), which is also the market demand curve and the demand curve facing Feet-First Pharmaceutical, and the marginal revenue curve (MR), which indicates the extra revenue received for selling each extra ounce of Amblathan-Plus.

Now consider the price elasticity of the average revenue (demand) curve. A straight-line demand curve such as this one has different ranges of elasticity.

For relatively high prices and small quantities, the average revenue (demand) curve is relatively elastic.

For relatively low prices and large quantities, the average revenue (demand) curve is relatively inelastic.

The average revenue (demand) curve is unit elastic at the exact midpoint of the line, which in this case is 10.5 ounces of Amblathan-Plus.

Click the [Elasticity] button to reveal this information.

The key question is how these elasticity alternatives relate to marginal revenue and total revenue.

When the average revenue (demand) curve is elastic, marginal revenue is positive and total revenue is increasing.

When the average revenue (demand) curve is inelastic, marginal revenue is negative and total revenue is decreasing.

When average revenue (demand) curve is unit elastic, marginal revenue is zero and total revenue is not changing.

The primary conclusion is that marginal revenue is negative and total revenue is decreasing in the inelastic portion of the average revenue (demand) curve. For Feet-First Pharmaceutical to maximize profit in the inelastic range it needs negative marginal cost, which is just not realistic.

The Monopoly Dream

To see why this conclusion is so important, consider how it appears to contradict what would seem to be dream of any aspiring monopoly.

To achieve monopoly status, a firm must supply a good that has no close substitutes. Buyers must be forced to buy from the monopoly if they buy the good at all. However, the availability of substitutes is a key determinant of demand elasticity.

Elastic Demand: A good with many close substitutes tends to have an elastic demand. Because buyers are easily able to switch between substitutes, they are relatively sensitive to price changes.

Inelastic Demand: A good with very few close substitutes tends to have an inelastic demand. Because buyers are not able to switch between substitutes, they are not very sensitive to price changes.

The dream of any monopoly seller is to provide a good for which there are no alternatives. Such a good, however, tends to be relatively inelastic. And consequently marginal revenue is negative, which prevents profit maximization.

Are these aspiring monopolies misguided? Should they be searching for goods with elastic demand? Are they unaware of the relation between elasticity and marginal revenue? Do they not know that they can never maximize profit if they produce a good with inelastic demand?

A Profitable Journey

The monopoly dream is not as misguided as it might first appear. The key is the phrase "profit maximization." Profit is MAXIMIZED when marginal revenue is positive and demand is elastic. In other words, when profit is maximized there is no way to INCREASE profit by doing something like increasing the price.

While profit maximization means profit can go no higher, the lack of profit maximization only means profit has NOT reached its peak. It does not mean profit is lacking. It does not mean that a monopoly firm is earning NO profit or incurring an economic loss. The lack of profit maximization ONLY means that the monopoly can take steps to increase profit. It can increase profit by doing something like increasing the price.

If a monopoly faces an inelastic demand curve, increasing the price is exactly what it can do. If the price of a good with inelastic demand is increased, then total revenue and profit also increase. Today the price is $1. Tomorrow the price is $2, and profit increases. The next day the price is $3, and profit increases again. When prices rise so too does profit. As long as demand is inelastic, then profit keeps rising. A "maximum" is not reached.

Is this is such a bad thing for the monopoly?

Not being AT THE MAXIMUM, but ONLY being able to increase profit is not really all that bad. Few firms would turn down the opportunity to be the sole provider of an inelastic product. Sure they might never MAXIMIZE their profit, that is, reach a nice stable equilibrium. But they can increase profit day after day, month after month, year after year, by raising prices. The "problem" is that profit can always go higher.

In the analysis of profit-maximization production, a monopoly NEVER selects an output level in the inelastic range of this demand curve. Feet-First Pharmaceutical NEVER willingly produces more than 10.5 ounces of Amblathan-Plus. Doing so requires that Feet-First Pharmaceutical operate with a quantity that generates negative marginal revenue.

If Feet-First Pharmaceutical found itself doing something like selling 15 ounces of Amblathan-Plus, then it undoubtedly raises the price, which reduces the quantity, which then increases total revenue, and which INCREASES profit. It continues this course until the quantity decreases enough to enter the elastic portion of the demand curve. Only there is Feet-First Pharmaceutical be able to MAXIMIZE profit. However, up to that time, profit merely INCREASES. Not such a bad thing for the monopoly.

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